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February 28, 2013

The Wrong Way to Soak the Rich

Joseph J. Thorndike

Back in December, President Obama squandered a tax increase. Intent on raising taxes for the rich -- and only the rich -- he lost his chance for a broader bargain. And more to the point, he may have imperiled the rate increases he did manage to wring from a reluctant Congress.

Tax increases are hard work, requiring a lot of effort and even more political capital. As a group, lawmakers are reluctant to raise taxes on anyone, even if a handful of outliers make a career of pushing rate increases on the rich. For most legislators, tax increases are at best a necessary evil.

Which makes it all the more important that when a president does go to the mat for a tax increase, he makes it a good one. And "good," in our current fiscal context, does not mean small. Or immediate, for that matter. Rather, the best tax increase for the United States circa 2013 is a large and distant one. In the fiscal cliff deal, we got neither.

December's deal is ancient history, of course, now that lawmakers are rushing headlong through a series of manufactured crises. But it's relevant because it represents both a wasted opportunity and an unnecessary obstacle. Bad tax increases get in the way of good ones.

Sequester Shenanigans

In his showdown with Republicans over the sequester, Obama insisted that any new deficit reduction plan include both spending cuts and tax increases. That position is reasonable and certainly consistent. The president has been singing this song since the start of his presidency. And in fact, he deserves credit for staying true to his word.

But having been strong-armed into accepting tax increases during the fiscal cliff negotiations, Republicans are in no mood to get rolled again. As a group, they have renewed their resistance to tax increases of any kind (unless they're actually revenue enhancements derived from base broadening, which lands us in a murky middle ground of post-Norquist redefinition).

As an element of ham-handed policymaking, the sequester is a masterpiece. As a way to cut deficits, it's ill-timed and poorly designed. Above all, it's a far cry from the sort of "grand bargain" that Obama says he wants.

But that bargain may be out of reach, if it was ever within Obama's grasp in the first place. The president's fondness for a particular type of tax increase -- a narrow one, targeting a variously defined group of undeniably rich people -- makes that bargain less likely than it ever was. The fiscal cliff deal -- with its feel-good rate increases for a tiny slice of the economic elite -- has made real tax increases harder to achieve.

Let's be clear: The rich can afford a tax increase. Between 1995 and 2009 (the latest year for which the IRS provides data), the average effective rate on the 400 richest taxpayers fell from 29.93 percent to just 19.91 percent. Those numbers are admittedly cherry-picked, because 1995 represented a modern high point. But the fact is that rates have been declining for rich Americans even faster than they have been for all Americans (they've been headed down for everyone since the 1970s).

The Wrong Way to Soak the Rich

But here's the key point: Even if your ultimate goal is soaking the rich, a narrow tax increase on solely the rich is not the best way to do it. In this case, history offers a pretty clear lesson. The most effective and durable tax increases on the rich have been enacted as part of larger, broad-based tax increases. World War II provides the most obvious example.

There have been exceptions, of course. The New Deal brought a series of progressive tax increases on the nation's economic elite. These were designed to be compensatory, after a fashion, making up for regressive excise taxes on consumer goods that supplied almost half of federal revenue in the early years of the Depression. FDR was intent on making the rich pay more, because he couldn't afford to have the poor pay less. Hence the major rate increases of 1935 (notable for a top bracket that was drawn so narrowly it included precisely one taxpayer, John D. Rockefeller Jr.).

We'll never know if FDR's soak-the-rich tax increases would have lasted. Within a few short years, World War II brought a range of new increases, including both higher rates on the rich and broad-based income taxes on the middle class. The New Deal experiment in soaking the rich -- and only the rich -- was subsumed in the much-vaunted transformation of the income tax from a class tax to a mass tax.

But there's another point of useful historical comparison besides the 1930s and 1940s. During World War I, lawmakers raised income taxes dramatically but kept the tax base narrowly focused on the rich. That earlier version of wartime income taxation was not really a "mass" tax, because it was never paid by more than 20 percent of the population.

But rates for those 20 percent went very high, indeed. The top bracket rate, which had made its debut in 1913 at just 7 percent, reached 77 percent in 1918. Quite a steep and speedy run-up for those at the top of the nation's economic pyramid.

Those rates, however, did not last. In the 1920s, a series of Republican presidents -- and one very determined Republican Treasury secretary, Andrew Mellon -- managed to push rates down across the board. Among the arguments they used to attack the wartime structure of the individual income tax was its narrow target. The income tax established during the war left too many people outside its grasp, they complained.

"As a matter of policy, it is advisable to have every citizen with a stake in his country," Mellon said. "Nothing brings home to a man the feeling that he personally has an interest in seeing that government revenues are not squandered, but intelligently expended, as the fact that he contributes individually a direct tax, no matter how small, to his government."

Mellon was no great fan of the income tax. But even some supporters of the levy worried that it was too narrow. "A tax system vitally important, as is the income tax, should apply to a respectable number of persons," warned Rep. Cordell Hull, a key legislative patron of the tax. Targeting the tax too narrowly would imperil its legitimacy, he suggested.

Hull was on to something. The rate reductions of the 1920s derived from a variety of factors, but the narrow base of the individual income tax certainly left the levy vulnerable. And a comparison to the period after World War II -- when a broad-based income tax managed to retain its high rates -- seems illuminating.

President Eisenhower tolerated high rates throughout the 1950s for a variety of reasons. But it seems likely that one of them was the broad tax base he inherited from the Roosevelt and Truman administrations. That base insulated the income tax from charges that it was a demagogic money grab.

This is circumstantial evidence, to be sure. But it should be sobering, nonetheless, for anyone intoxicated by the progressive -- but largely symbolic -- tax increases of the fiscal cliff deal.